A Technical-Fundamental System for Stock Selection

Grant Henning—a trader, author and former university professor—believes that market trends will dictate whether to weight a stock portfolio toward value and earnings stocks or momentum and growth stocks. He also believes that the equity market goes through “predictable” patterns. By recognizing these patterns, he feels that it is possible to identify periods where it is advantageous to own stocks and when it is not.

Henning considers himself a swing trader, holding stocks for as little as a day or two or as long as a couple months. Having such a narrow trading window, in his opinion, allows him to take advantage of price fluctuations.

For his own trading, Henning defines success as averaging a 10% gain, per month, on his invested capital. If he fails to achieve this goal over an extended period of time, he will re-evaluate the system to see if adjustments are necessary or whether he needs to adopt an entirely new system.

In his book “The Value and Momentum Trader” (John Wiley & Sons, 2010), Henning begins by outlining first the technical and then the fundamental models he has developed. Henning’s research indicates that his technical-momentum factors performed better during bull markets while his fundamental-value variables tended to do better during bear markets. Being a pragmatist, and knowing that neither bull nor bear markets last forever, he developed a trading model that combines elements of both models into a hybrid fundamental-technical methodology.

Qualifying Variables

Henning begins his search by creating a watchlist of roughly 200 stocks. To isolate the stocks in his watchlist, he applies three “qualifying variables”—share price, volume, and price gain (three-month and one-year). He admits that the thresholds he uses for these qualifying variables are somewhat subjective, but these are the hurdles he uses in his own trading.

Share Price

Henning only invests in stocks with a share price above $5. For him, this minimizes the risk of buying stocks that are prone to price manipulation. His experience has also shown that as stocks pass key price levels—$5, $10, etc.—the level of institutional investment and liquidity increases. Trading requires higher levels of liquidity than long-term investing.

Volume

Next, Henning limits his investments to those stocks that average at least 10,000 shares traded per day. Investing in low-volume stocks may prevent you from quickly exiting a position without forcing the share price down, which would lower your gains.

Furthermore, although he does not use it as part of his filtering process, Henning likes to see the trading volume increasing over the last month or so.

One-Year & Three-Month Gains

The final set of qualifying variables Henning uses relates to price change. Specifically, he looks for stocks with sufficient price momentum.

First, he only considers stocks that have at least doubled in price over the last 52 weeks. Furthermore, he wants stocks on his watchlist to have risen at least 30% from the lowest price level over the last three months.

Technical-Momentum Variables

Using AAII’s fundamental stock screening and research database program, Stock Investor Pro, we applied Henning’s qualifying criteria to the universe of companies as of July 9, 2010, and came up with 116 stocks for the watchlist. Table 1 is a subset of these companies, which are used to discuss the technical-momentum factors Henning applies in his hybrid trading model.

Henning prefers to begin with technical variables because he believes they are more restrictive and that they uncover stocks that are under accumulation by traders.

Early in his trading career, Henning relied more on value-based elements for his decisions. However, he discovered one of the pitfalls of value investing—value stocks can remain at value prices for months or even years. By using technical-momentum elements as part of his trading system, Henning hopes to reduce the time it takes for the market to recognize that a stock is, in fact, undervalued.

52-Week Price Multiple

The 52-week price multiple column in Table 1 represents the number of times the share price has multiplied from its 52-week low over the same period. It is calculated as follows:

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Current Price ÷ 52-Week Low Price

Since one of the qualifying variables requires the stock price to have doubled over the last 52 weeks, every stock in our watchlist should have a 52-week multiple of 2.00 or more.

*Calculation may vary from the table because of rounding of dependent variables.
**Calculation relied on all 114 stocks in the watchlist.
Exchange Key: M = NASDAQ; N = New York Stock Exchange.
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 7/9/2010.

Percentage Lag

Percentage lag measures the degree to which the current share price “lags” or falls below the 52-week high price. It is calculated as follows:

[52-Week High Price – (Current Price – 0.02)] ÷ 52-Week High Price

Another way to calculate percentage lag is by subtracting price as a percentage of 52-week high from 1.0.

To avoid the problem of dividing into zero when the current price and the 52-week high are both the same, Henning arbitrarily subtracts $0.02 from the current share price.

When evaluating the percentage lag, the smaller the value the better. This means that the current price is close to the 52-week high. For Henning, anything above 3% (0.03) presents an “overhang problem,” where people who bought the stock at prices that are higher than where the price is currently are waiting to sell their shares at a minimal loss. Therefore, while the price may increase, it is reasonable to expect this rate of increase to be lower than shares without this overhang problem.

However, Henning disregards those stocks in his watchlist where the current share price is less than half of its 52-week high (a percentage lag of more than 0.50). According to him, an exception to this rule may be made during extreme bear markets. During these times, as Henning puts it, good companies can still suffer large price corrections. Therefore, Table 1 excludes any stock with a percentage lag value greater than 0.50, which drops the watchlist from 116 companies to 114.

Investment Value

The next column in Table 1 is the investment value. This is a variable Henning created, which is a weighted rate-of-ascent (increase) value (52-week multiple) divided by a weighted percentage lag value (in its decimal form). The formula is as follows:

(3 × 52-Week Multiple) ÷ (2 × % Lag)

Based on this calculation, stocks with high 52-week price multiples and smaller percentage lag values benefit relative to stocks with lower multiples and higher percentage lag. For his own trading, Henning prefers stocks with investment values over 100, although he does not exclude stocks with investment values of less than 100 from his watchlist.

Initially, Henning ended his technical evaluation with investment value. However, he realized that the 52-week price multiple could be unduly influenced by a large price increase early on in the year only to then stagnate for the remainder of the year. Likewise, a stock may decline during the middle of the year only to rebound quickly to its pre-decline value but go no further. Henning realized he needed a way to “smooth” the rate-of-ascent curve and give priorities to those stocks that continued to experience strong price gains throughout the year. He did this using two other variables—three-month price gain and “rank.”

Three-Month Price Gain

The three-month price gain is the same variable we used when arriving at our watchlist. It is slightly different than a simple percentage change in price over the last three months. Instead, Henning uses the lowest intraday price over the last three months and calculates the percentage increase from that point to the current price. The calculation is as follows:

Again, since Henning is interested in averaging a 10% gain on his investments per month, he eliminates any stocks that have not increased by at least 30% from their low of the last three months.

Investment Value Rank

The last technical variable Henning uses involves ranking the watchlist from lowest to highest based on the investment value and comparing the adjusted rank value to the three-month price gain. This can be accomplished using the rank function in the Microsoft Excel spreadsheet program. Henning describes this rank calculation as the primary technical stock selection variable; all of the variables we have covered thus far are needed to generate the rank data.

Using Excel, Henning uses the rank function to first order and smooth the investment value data for each stock. The results are then divided by the three-month price gain to give priority to those stocks experiencing strong upward price movement over the last three months.

Using the company data in Table 1, the investment value rank calculation would be as follows:

Inv Val Rank = (RANK (G6, G$6:G$25, 0) * 2 + 100) / H6

Where:

RANK is the Excel rank function;

G6 is the first data cell of the Investment Value column;

G$6:G$25 is the designation of range for the rank function;

0 signifies that the rank statistic will be expressed in ascending order (smallest to largest); and

H6 is the first data cell in the three-month price gain column.

The companies in Table 1 are the 20 companies with the lowest (best) investment value ranks from the 114-stock watchlist as of July 9, 2010.

Scoring the Technical Variables

After calculating the variables in Table 1, the next step is to assign points based on the level of each variable for each stock (Table 2).

Henning assigns points in the following fashion:

One point is awarded for percentage lag values of 0.035 (3.5%) or less;

One point is awarded for investment values greater than 100;

One point is awarded for three-month gain values above 100%; and

One point is awarded for investment value ranks less than 1.5.

Additional Technical Analysis

After performing his “quantitative” analysis of this watchlist using these technical-momentum variables, Henning uses two websites to perform additional technical-momentum analysis of the stocks on his watchlist.

First, he analyzes point & figure charts for the stocks on his watchlist using the StockCharts website (www.stockcharts.com). [Computerized Investing subscribers will find a discussion of point & figure charts in the “Technically Speaking” column in the Second Quarter 2010 issue.] When you pull up a point & figure chart for a given stock, the site sometimes provides green buy signals or red sell “P&F Pattern” signals based on common point & figure chart patterns. If a stock has a green bullish point & figure signal, Henning awards it one point. When there is a red bearish signal, one point is deducted for that stock.

Lastly, Henning uses the “opinion” section of the BarChart website (www.barchart.com). Here you can get estimates of a stock’s short-, medium-, and long-term technical prospects based on 13 different technical indicators.

Henning awards a point to stocks with an overall average rating of 96% Buy to 100% Buy. For stocks with an average rating of 25% Buy to 95% Buy, zero points are awarded. Finally, any stock with a rating below 25% Buy loses one point.

Table 2 shows the points awarded for the six technical variables Henning uses in the hybrid model, along with the final tally for all the technical variables. IDT Corporation IDT and Power-One, Inc. PWER are the only two companies out of the 20 that rate a perfect six out of six with the technical criteria.

Fundamental-Value Variables

The second half of Henning’s hybrid model involves using fundamental variables that have performed well as indicators of future price growth, based on Henning’s own multiple regression analysis. While we use the fundamental data from Stock Investor Pro for our analysis, Henning uses free financial websites, including Yahoo! Finance, to collect this data.

Price-Earnings Ratio

Henning describes strong earnings performance as being the “hallmark of any value-based approach.” Henning prefers stocks with earnings per share that are 10% or more of price per share. This translates into a price-earnings ratio of 10 or less. However, he assigns points on this basis:

A price-earnings ratio of five or less receives two points;

A price-earnings ratio greater than five but less than 12 receives one point;

A price-earnings ratio greater than 12 but less than or equal to 25 receives zero points; and

A price-earnings ratio greater than 25 or where earnings are negative loses one point.

Book Value

Henning recognizes that there are numerous ways to estimate the value of a stock—price to earnings, price to sales, price to cash flow, etc. However, he chooses to use book value because he feels it most closely approximates the liquidation value of a company and, thus, offers a measure of safety.

When examining the price to book value of a stock, Henning awards points as follows:

A price to book value less than two receives one point;

A price to book value greater than two and less than or equal to four receives zero points; and

A price to book value above four loses one point.

Earnings Growth

For Henning, great earnings are only one piece of the puzzle. He also seeks out companies with records of strong, consistent earnings growth quarter to quarter.

To evaluate the earnings growth of a company, he compares the quarterly earnings history to forecasted or future earnings. To do this, he compares the current price-earnings ratio based on earnings for the trailing 12 months (last four fiscal quarters) to the forward price-earnings ratio based on estimated earnings. Ideally, the forward price-earnings ratio will be “substantially lower” than the historical price-earnings ratio.

Henning also compares the company’s price-earnings ratio (P/E) to the average price-earnings ratio for the companies in the S&P 500 large-cap index. Using Professor Robert Schiller’s stock market data, the price-earnings ratio for the S&P 500 as of July 9, 2010, was 19.6.

Henning then awards points as follows:

One point is awarded when the forward P/E is less than the historical P/E and is lower than the average P/E for the S&P 500;

Zero points are awarded when the forward P/E is greater than or equal to the historical P/E and is less than the average P/E for the S&P 500; zero points are also awarded if there is no forward P/E data; and

One point is deducted if the forward P/E is greater than the average P/E for the S&P 500, irrespective of its level relative to the historical P/E.

EPS-P/E Divergence

Henning views a positive divergence between rolling 12-month earnings per share EPS and the price-earnings ratio as a strong indicator of future price growth. Henning defines this type of divergence as an increase in earnings per share that does not lead to an increase in the price-earnings ratio or an increase in share price. Holding all else equal, an increase in earnings per share would lead to a decline in the price-earnings ratio.

Henning awards points based on EPS-P/E divergence in the following manner:

When rolling earnings per share is increasing, the price-earnings ratio is level or declining, and the share price is below levels when the rolling earnings per share was lower, one point is awarded;

When rolling earnings per share is increasing, share price is increasing, and the price-earnings ratio is above prior levels or market averages, zero points are awarded; also, if no price-earnings data is available or if the price-earnings ratio is negative, zero points are awarded; and

When rolling earnings per share are declining, irrespective of price movement or price-earnings changes, one point is deducted.

To help him in this analysis, Henning uses the BigCharts.com website (www.bigcharts.com). Figure 1 is a daily price chart for IDT for the past year, with additional plots of rolling 12-month earnings per share and price-earnings ratio. IDT announced quarterly earnings of $0.58 per share on June 10, 2010, which boosted the company’s rolling earnings per share to $1.40 from a loss of $0.41 per share. While the stock price and the price-earnings ratio initially dipped following the earnings announcement, by the time we ran our analysis on July 9, 2010, IDT shares had already risen over 90% since the announcement. While the rolling EPS increased, IDT’s price-earnings ratio and share price have undergone significant increases. This leads us

to award zero points based on Henning’s EPS-P/E divergence criteria.

Cash Flow & Free Cash Flow

Henning believes that cash flow is perhaps the best indicator of a company’s future earnings and, thus, price growth.

He describes “cash flow” as the net cash flowing into or out of a company. He also describes “free cash flow” as cash that is “unencumbered by operational expenses.” This seemingly corresponds to the traditional definition of free cash flow, which is defined as cash from operations less capital expenditures and dividends paid. While Henning views free cash flow as the more important measure, he considers both because the two often differ greatly from one another.

Unfortunately, Henning uses some confusing terminology when discussing cash flow and free cash flow. While he refers to “cash flow per share” and “free cash flow per share” he goes on to compare them to price-earnings ratios. Furthermore, he uses the exact same ranges when assigning points to cash flow and free cash flow, which leads us to believe he actually means price to cash flow and price to free cash flow.

Henning uses a unique metric to consider cash flow and free cash flow—he takes the average of the current price to cash flow and price to free cash flow. He awards points thus:

• One point is awarded for positive values less than 12.5;

• Zero points are awarded for values greater than 12.5 and less than or equal to 25; and

• One point is deducted when values are greater than 25 or if either cash flow or free cash flow is negative.

Table 2 shows the points awarded for the five fundamental variables of Henning’s hybrid model, along with the final tally for all the fundamental variables. The fundamentals are not nearly as solid for this group of stocks, with IDT Corp. scoring the “best” while only garnering two of the possible five points.

Tallying the Results

Once he has quantified the variables used in his technical-fundamental hybrid approach, Henning tallies the results and assigns a recommendation to each of the stocks in his watchlist.

There are six technical indicators and five fundamental indicators in Henning’s hybrid model. In theory, a stock can have a rating that ranges from −11 to +11. However, since he eliminates stocks with a percentage lag greater than 50% and three-month gain of less than 30%, he rarely assigns negative values for those indicators.

Table 3 shows the grand totals for the 20 stocks we have been tracking throughout the article. Of these 20, only IDT Corp. rates a Buy, as its “score” of eight translates into a Strong Buy recommendation based on Henning’s scale. Power-One, Inc. PWER, the other stock that had a “perfect” technical rating, rates a Weak Hold while the other 18 stocks in Table 3 rate some level of Sell.

Henning warns of the transitory nature of his ratings, especially considering that more than half of the variables of his hybrid model relate to price activity. For this reason, he suggests never investing more than 10% of your available capital in any one stock.

Conclusion

While stock-picking strategies are often rooted in either value and fundamentals or momentum and technicals, Grant Henning attempts to blend the two.

His reasoning is that growth-momentum approaches typically do better during bull markets, while value-fundamental strategies tend to outperform during bear markets. Instead of trying to time the market to switch between the differing strategies, Henning combines fundamental and technical criteria into a singular trading model. His goal is to identify stocks that are likely to rise in price based on both historical performance and expected future performance.

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